Correlation, price discovery and co-movement of asset-backed securities and equity
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Practical applications On the heels of prominent and headline-grabbing downgrades and defaults of several U.S. corporates in 2005, subsequent haircut unwinding of CDO and CDS positions exposed to these corporates did not only resuscitate regulatory concerns about risk measurement standards, but also raised groundswell concern about the knock-on effects of shocks in derivative markets on other investment classes. In this regard, the paper explores one possible inter-linkage based on a reduced form simultaneous equation model of the joint price dynamics of publicly traded equity and default sensitive asset-backed securities (ABS) issued by the same entity. Estimation results suggest a consistent long term intertemporal association between both asset classes, which ascribes information benefits to ABS as a leading indicator of price discovery. The negative correlation of investment-grade ABS and equity provides an attractive long-term hedging possibility at times when declining ABS spreads would allow equity holders to cover their asset position in anticipation of falling share prices. These findings are particular useful for finance executives of corporations seeking alternative ways of diversified funding, institutional investors, hedge fund managers and investment banks in the structured finance market as well as service providers, such as risk consultants and prime brokers. Abstract Asset-backed securitisation has become a viable and increasingly attractive risk management and refinancing method either as a stand-alone form of
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structured finance or as securitised debt in collateralised debt obligations (CDO). The absence of industry standardisation, however, has prevented rising investment demand from
Derivatives Use, Trading & Regulation V olume T welve Numbers One/Two 2006
Derivatives Use, Trading & Regulation, Vol. 12 No. 1/2, 2006, pp. 60–101 䉷 Palgrave Macmillan Ltd 1747–4426/06 $30.00
translating into market liquidity comparable with traditional fixed income instruments, in all but a few selected market segments. In particular, low financial transparency and complex security designs inhibit profound analysis of secondary market pricing and how it relates to established forms of external finance. This paper represents the first attempt to measure the intertemporal, bivariate causal relationship between matched price series of equity and ABS issued by the same entity. In a two-dimensional linear system of simultaneous equations, it investigates the short-term dynamics and long-term consistency of daily secondary market data from the UK sterling asset-backed securities (ABS)/mortgage backed securities (MBS) market and exchange traded shares between 1998 and 2004 with and without the presence of cointegration. The causality framework delivers compelling empirical support for a strong co-movement between matched price series of ABS-equity pairs, where ABS markets seem to contribute more to price discovery over the long run. Controlling for cointegration, risk-free interest and average market risk of corp
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